5 Easy Tips for Picking Mutual Funds

In one our recent issues subscriber Jory G. sent us the following question:

“I have a 401(k) with my present employer
that has a number of investment options, virtually all of which are
mutual funds. Is it possible for Mr. Miller to address in a future
letter what we might do to maximize growth or minimize loss in such
programs? I realize there are many different 401(k) programs out there,
but I just feel overwhelmed when trying to decide which of the funds
provide the best growth/protection.”

As all of our readers know, I am neither licensed nor qualified to
give personal investment advice. However, I can sure discuss mutual
funds in general.

Jory, I would like to back up and start at the beginning.

I recommend that all of our subscribers read The Intelligent Investor by the late Benjamin Graham. While the last revision was about a decade
ago, many of his basic principles are still applicable in today’s
market.

He classified investors into two groups, active and passive. For
Graham, passive investors had to be willing to accept lower returns;
that’s the tradeoff for not staying on top of things.

With a mutual fund, you pay an expert to invest your money for you.
Ideally, he does a better job than you could individually. In the early
days, folks like Sir John Templeton did a darn good job of it. Over
time, major brokerage firms saw the huge fees these funds were charging
and decided to set up their own funds. Brokers began to channel clients
into their in-house funds, often under a great deal of pressure. Some
did well and some did poorly, but all generated nice fees for the fund
manager.

Two of my adult children have asked me similar questions. Their
companies’ retirement brochures asked them to decide between mutual
funds described as “index, conservative, aggressive, mid-cap, large-cap,
or moderate.” Just a few adjectives without much explanation, and
that’s the basis for deciding where to invest a large portion of your
life savings!

During the economic boom times, despite some high fees mutual funds
did pretty well. Things then began to change. In 1996, The Motley Fool
Investment Guide took most of the mutual-fund industry to task. The
premise was that the only way to accurately gauge a mutual fund is to
compare its performance to the S&P 500. If could buy an S&P 500
index fund, pay much lower fees, and still beat 80% of mutual funds,
what was the point of paying a fund manager?

Basically, when economic times were good, most mutual funds made
money for their investors. But then again, an S&P 500 index fund
would have also done the trick.

Vedran Vuk, lead analyst for Money Forever, wrote a piece in the Casey Daily Dispatch a while back about a fund manager named Bill Miller (no relation) – a real Wall Street darling who beat the S&P 500 for
15 straight years. When the market turned in 2007, however, he wagered
on financial stocks, and his fund dropped 55%; the S&P only dropped
37%.

So what can we learn from Bill Miller? In boom times, we can all do
well. Folks can invest in mutual funds, peek at them every three months
or so, and still expect to do reasonably well. That’s the ultimate
description of a passive investor – but it won’t work in today’s
economy.

Over the last 20 years, Bill Miller did well over the first thirteen;
the next six years were terrible; and then last year he had a huge
gain. Investors’ results varied depending on when they bought into his
fund. As you get closer to retirement, you’re probably looking for a
little more stability – for both your wallet and your peace of mind.

Please do not misunderstand my message. I am a firm believer in
maximizing your contributions to any company-sponsored pension plan,
401(k), IRA, or whatever other retirement plan is available to you. Most
are tax deferred, so they lower your tax bill while helping you
accumulate long-term wealth.

With that said, you should not approach any company-sponsored
retirement account as a passive investor. Here are a few tips for
understanding your options and investing wisely:

1. Look at the fees.
Some mutual funds charge up to 2% to manage your money. That’s a heck
of an obstacle to overcome in a tough market; you have to earn at 2%
just to break even. Only a terrific performance can justify those high
fees.

2. Five-Point Balancing Test. Look at each fund in light of our five criteria. Go online and see where the bulk of their investments stack up.

3. Diversify. If
your company has more than one investment option, diversifying among
funds is not a bad idea, particularly if some are specialized funds
(small cap, energy, etc.). If you can instruct your fund manager on what
percentage of your money to put in each fund, that’s even better.

4. Index Funds. In
2012, 65.44% of the large-cap active managers lagged behind the S&P
500, 81.57% of mid-cap funds were outperformed by the S&P MidCap
400, and 77.73% of the small-cap funds were outperformed by the S&P
SmallCap 600. Over the last five years, approximately 24% of domestic
equity funds, 22% of international equity funds, and 15% of fixed-income
funds merged or liquidated.

The goal with any company-sponsored retirement plan is to have steady
growth so you can retire comfortably. Consider all the options. If most
of the other funds cannot beat the lower-cost index funds, consider
putting a larger percentage of your portfolio into an index fund.

5. Don’t set it and forget it. Any plan should allow for annual adjustments. Take the time to study its performance and make any necessary changes each year.

I do want to add one final point. If you are investing outside of a
company-sponsored plan, there are many ETFs with the advantages of a
mutual fund, but without the high fees. Our team covers ETFs at length
in two recent reports, The Yield Book and Money Every Month, so take a look, and remember to apply the same points I outlined above for Jory.